A Very Long-Term View Of Government Finances - Implications For The S&P 500

In late September, 2013 the Congressional Budget Office (CBO) released a very long term forecast of the U.S. fiscal position. The forecast stretches to 2088 and it is based on current law as pertains to tax policy, entitlements, and the Affordable Care Act. The forecast assumes a winding down of military operations abroad and peace for our generation and those proceeding ours.

While the political establishment has been focused on policies affecting the cyclical deficit, there has been little focus on those affecting the structural deficit. This shows up starkly in CBO's long term forecast. From the accompanying table the CBO shows that by 2088 the federal deficit would reach 14.2% of GDP versus approximately 4% this year. The federal debt held by the public would be 245% of GDP by 2088, up from 68% currently. As shown in the table these ratios, which are currently at tolerable levels, begin rising sharply and sustainably after 2025.

According to CBO there are two major drivers of this long term increase in debt and deficit. The first is federally financed health care and the second is the net interest burden of the federal debt. Social security outlays is a distant third.

Federal health care spending is shown to rise from roughly 4.7% of GDP this year to 13.8% at the end of the forecast period. Of this total spending on Medicare rise from 3% to 9.4% of GDP and the remainder, which includes Medicaid, child health insurance, and subsidies related to the Affordable Care Act is forecast to rise from 1.7% to 4.4% of GDP.

Net interest on the federal debt is the second main driver and it is forecast to rise from 1.3% of GDP currently to 12% of GDP by the end of the forecast period. The growth in interest expense is essentially a function of the increase in the debt held by the public and the level of interest rates. Of course, forecasting interest rates beyond a week is treacherous. Forecasting rates 70 years into the future is pure folly. But what can be said is that rates are currently closer to a perceived bottom than a possible top so the best news on the interest rate front is probably upon us. The CBO essentially punts on this item, forecasting a steady state rate of about 5.5% from the latter part of this decade forward.

These two drivers of federal finance move from 6.4% of GDP currently to 25.8% of GDP by the end of the forecast period. What is more astounding is that the sum of spending in these two areas is an increase of 19.4% of GDP compared to the entire projected deficit of 14.2% of GDP by 2088. The upshot is that CBO projects that all federal spending excluding health care and net interest will actually decline from 14.5% of GDP currently to 12.7% of GDP eventually. Considering that outlays for social security are projected to rise from 4.9% of GDP to 6.7% of GDP, the reductions elsewhere are even starker.

Needless to say, one important step toward bending these trends is to move from a position of recurring deficit to one of persistent surplus. This would drive down the relative and absolute level of debt, thus reducing the burden of net interest expense. Moving toward such condition in the absence of major policy changes could occur if economic growth were higher than the approximate 2.5% trend rate assumed by CBO. For example, everything else constant, if growth were 0.2% per year higher than the CBO forecast in every year after 2015, by 2086 the deficit would disappear and the debt-GDP ratio would be a very manageable 45%.

The other way of bending the trends projected by CBO would be via policy changes on taxes and health care spending. Regarding tax policy the CBO actually projects that revenue would rise from 17% of GDP currently to 24.5% by 2088. Since the historic norm for this ratio is about 18%, raising the ratio beyond that forecast by CBO would seem very difficult to accomplish politically.

Thus, it would seem that from the expenditure side the bonus for bending the trend lies with controlling health costs and to a much lesser degree social security. This is of course the crux of the underlying debate that is currently being waged over the short term and long term effectiveness of the Affordable Care Act and entitlement spending. So at least the focus is on the right issue even if the debate carries sometimes silly overtones.

We will not address these socioeconomic issues in this report. Rather, our focus is on the implications of these trends for the market multiple and the S&P 500. The good news here is that our model relating earnings to GDP and unit labor cost predicts earnings of 3039 in 2065. The forecast is for about a 30 fold increase from current levels or about a 6.5% annualized growth rate. This is not at all unreasonable. Beyond 2067 the market multiple actually goes negative which is meaningless and is why we do not forecast the S&P 500 beyond 2065. This reflects the explosion in federal spending relative to GDP which of course is a prime input in the market multiple model.

The bad news is from our model of the market multiple. Because the spending - GDP ratio rises steadily and sharply over time, the market multiple would soon reach a peak and fall steadily toward zero in about 50 years. (The model had no observations of the ratio above 25% during the historical estimation period, so the huge increase projected by CBO has an outsized effect.)

While the multiple will not fall to zero in the real world, the single digit values that commence in 2035 are probably not unrealistic. As a result, while the S&P 500 index is forecast to rise by an average 2% between 2020 and 2035 the period from 2035 to 2060 is largely one of stagnation, with the strategy being to get out of the way after 2050. To make money one had better be a superior stock picker.

The forecasts presented in this outlook may be taken with a grain of salt, and small changes in some of the underlying variables can have outsized implications. This we demonstrated by simply altering the underlying GDP growth rate. However, the point is that 2013 may in fact be marking the departure point for a long and acrimonious debate over the basic structure of health care in America i.e. its financing, its delivery, and its demographic burden sharing.

CBO BASELINE PROJECTIONS

MODEL PROJECTIONS

Year

Nominal GDP (Billions of dollars, fiscal years)

Real GDP growth rate (fiscal years)

Unit Labor Costs Mnfg

Average Annual 10-year treasury interest Rate

Total Federal Spending as % of GDP

Federal Debt Held by the Public as a % of GDP

Market P/E Multiple S&P 500

Earnings S&P 500

S&P 500 Index

2010

14499

3.1

-5.0

3.22

24.1

62.9

15.03

83.66

1257.6

2011

15064

1.6

1.4

2.78

24.1

67.8

12.96

97.05

1257.6

2012

15682

2.3

1.3

1.8

22.8

72.5

13.92

102.47

1426.2

2013

16600

1.4

1.0

2.5

20.8

73

18.6

108.1

2010

2014

17200

3.0

1.3

2.6

20.9

74

19.4

111.3

2160

2015

18300

4.1

1.6

3.5

20.7

72

18.5

126.5

2345

2016

19500

4.5

1.6

4.3

20.8

70

17.6

140.8

2481

2017

20700

3.7

1.7

5.0

20.6

69

16.7

148.3

2472

2018

21700

2.6

1.8

5.2

20.7

68

16.2

151.0

2450

2019

22700

2.0

1.8

5.2

21.0

69

15.9

157.5

2503

2020

23700

2.5

1.8

5.2

21.2

69

15.5

170.7

2649

2021

24700

2.4

1.8

5.2

21.4

70

15.1

181.1

2728

2022

25700

1.9

1.8

5.2

21.8

70

14.5

188.2

2733

2023

26800

2.3

1.8

5.2

21.8

71

14.0

204.0

2857

2024

28000

1.8

2.0

5.5

22.2

72

13.3

213.0

2823

2025

29100

2.2

2.0

5.4

22.5

73

12.9

228.9

2958

2030

35300

1.6

2.0

5.5

24.3

83

11.0

297.5

3282

2035

43700

2.2

2.0

5.5

25.5

93

9.5

420.2

3988

2040

54400

2.3

2.0

5.5

26.6

105

8.1

587.1

4769

2045

67700

2.4

2.0

5.5

27.6

116

6.7

818.7

5503

2050

84000

2.1

2.0

5.5

28.6

129

5.3

1122.8

5896

2055

104500

2.6

2.0

5.5

29.7

141

3.6

1592.7

5696

2060

129800

2.1

2.0

5.5

31.0

154

1.9

2166.8

4119

2065

161700

2.3

2.0

5.5

32.2

168

0.1

3038.6

373

2070

201500

2.2

2.0

5.5

33.5

183

NA

4224

NA

2075

251000

2.3

2.0

5.5

34.9

199

NA

5903

NA

2080

312800

2.2

2.0

5.6

36.4

216

NA

8195

NA

2085

390200

2.2

2.0

5.5

37.7

233

NA

12085

NA

2088

445000

2.1

2.0

.5.5

38.7

245

NA

15467

NA

Click to enlarge

Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.